J.P. Morgan stunned the financial markets with news that its earnings would be far below expectations due to a quadrupling of bad loans of $1.4 billion during Q3. Trading profits at the bank fell from $1.1 billion from the previous quarter to just under $100 million. This is a bank in deep trouble and in all the wrong places. The markets shouldn’t have been stunned by the news. Anyone with an IQ over 100 should be able to look at Morgan’s derivative book, now at over $25.9 trillion, and see this isn’t a bank, but a hedge fund--a hedge fund that makes LTCM and Enron look like t-bill money market funds. Look at the risks taken by LTCM and Enron and then multiply that by a power of 10. This bank looks, acts and resembles a hedge fund run on steroids, methamphetamines, and caffeine.
Its high risk lending and high risk trading operations have begun to backfire on the bank in spades. They are losing money in lending and it looks like they could lose money on the trading side. The bank’s profits, which peaked at $5.73 billion in 2000, have fallen steadily since then. Profits fell 71% in 2001 to $1.69 billion. Many analysts expect them to earn nothing in the third quarter, and it’s anyone’s guess as to what the fourth quarter will bring. The bank’s $47 billion in outstanding bonds were downgraded by S&P and by Fitch. S&P said the worst might not be over for the troubled bank. With its debt downgraded to A+, it hurts the bank. More importantly, if the bank’s debt is lowered one more notch to A, it could be the beginning of the end. An A rating could start a downward spiral. Credit-rating cuts mean higher borrowing costs for J.P. Morgan. Investors begin to demand higher yields to compensate for higher risks. Because the bank derives so much of its revenue from trading high-risk derivatives, a lower credit rating means that trading partners would demand more collateral to do business with the firm. When you consider that the bank’s derivative book now exceeds $25.9 trillion, this factor becomes significant. Lower ratings could begin a downward spiral caused by the unwinding of the bank’s derivative book in a situation similar to what happened to Enron. In the case of Enron, it looks conservatively managed when compared to operations at Morgan.
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